The ECB cut its base interest rate by 50 basis points to 2.75% in December, the lowest level in more...
The ECB cut its base interest rate by 50 basis points to 2.75% in December, the lowest level in more than three years.
Having staunchly refused to reduce rates, when many believed a cut was overdue, the bank now appears to have adopted the view a cut will help boost confidence without damaging the prospects for lower inflation into 2003.
The ECB appears to have finally acknowledged the slow pace of economic activity in the euro area. Eurozone GDP in the latter part of 2002 was growing, but only at the lower range of the bank's expectations. Domestic demand remains somewhat weak and private consumption has slowed as the labour market weakens and consumer confidence deteriorates.
Germany is the largest economy within the eurozone, which gives it significant importance and influence in defining the regional outlook. For some time, economic growth prospects in Germany have remained particularly weak, with the indicator for economic sentiment falling close to its all time low in 1993 when GDP contracted.
Although the economy is not as weak as it was at that time, growth is expected to be less than 1% in 2003 and there is a risk the German economy will tip into recession.
Indeed, if interest rates were being set according to domestic conditions rather than centrally by the ECB, the problems faced would be highlighted. We would have interest rates of around 13% in booming Ireland, compared with less than 2% in struggling Germany.
The important point is that for all countries in the eurozone bar one, the ECB base interest rate of 2.75% is below the rate that would be justified by domestic conditions. The one exception is, of course, the region's largest economy, Germany. If the Bundesbank was still setting policy, interest rates in Germany would be less than 2%, based on simple calculations.
This raises another issue, that of whether the ECB should set policy for the average or for the weakest member of the region.
In normal circumstances, the average is probably about right. However, these are not normal times. Germany faces the prospect of deflation, with current inflation slowing considerably. With unemployment rising and a significant amount of slack in the economy, pricing pressures will probably fall further. If Germany were to slip into deflation, as we have seen in Japan, monetary policy would become impotent. When demand is weak and inflation low, policy needs to be set for the weakest member to head off the risks of falling into the deflation trap.
Germany's place as a global leader is also being called into question. Weakness in the US has highlighted the lack of any significant growth engine in the rest of the world. Domestic demand in both Japan and Germany has fallen through 2002 and looks set to continue into 2003.
As a result, prospects in Europe and Asia have become more closely tied than ever to the fortunes of the US. Where once investors could turn to the traditional powerhouses of Europe or Asia for some support in times of US slowdown, these countries are currently among the weakest economies in their respective regions.
ECB now looks more accommodating.
Interest rates at lowest level for three years
Economies growing, although muted.
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